GAM's chief economist and head of investment solutions explains why we should expect some key changes over the remainder of 2017.
'After a strong start to the year for risk assets, driven by resilient global growth, improved corporate earnings and receding political risk, the central question under discussion at our asset allocation committee meeting was whether investors should expect more of the same in the months ahead.
Although much speaks for continuity, particularly for the outperformance of stocks versus bonds, the committee anticipates several key changes in investment performance over the remainder of 2017.
Importantly, the reasons why global equities are likely to outperform have begun to change. From mid-2016 until the end of Q1 2017 positive global growth surprises and expectations for pro-growth policies in the US underpinned strong equity returns and rising bond yields.
Both of these factors have become less dominant. Growth surprise indices have peaked as consensus forecasts have caught up with the improved dataflow. To be sure, there are few signs that underlying global growth has slowed. If anything, activity continues to gently accelerate in most
Meanwhile, expectations for US healthcare and tax reform, and for fresh infrastructure spending, have receded as the Republican majority in Washington has struggled to unite. Accordingly, ‘Trumponomics’ has faded as a dominant market driver.
But even if the ‘reflation trade’ has stalled, equities remain likely to outperform bonds for three primary reasons:
Despite lofty US valuations, global equities are well supported by improved earnings. Compared to a year ago, corporate profits are up over 10% in both the US and Europe and economic conditions and policy settings remain broadly positive. Valuations alone, are rarely the source of sustained market setbacks, particularly when fundamentals are favourable.
Regional and sector-specific themes are capturing investor imagination. Economic recoveries in Europe and much of the emerging complex underpin expectations for a cyclical profits recovery where it has thus far been absent. Dominant technology companies are also in favour, a sign not only of the importance of disruptive innovation, but also of investors’ willingness to discount more lightly future cash flows.
Central bank normalisation is keeping bond markets on the defensive, but without eroding the case for equities. The Fed’s statement dismissing weak US first quarter growth as ‘transitory’ confirmed the central bank’s commitment to gradual tightening, but also reassured investors about resilient growth. Similarly, the Fed’s willingness to consider balance sheet adjustment before year end has been confidence enhancing. And with the French presidential elections over, bond markets are likely to be on the defensive as expectations grow that the ECB will shift to a less dovish stance later this year.
The impact on asset allocation
In short, the underlying drivers of market returns are shifting, but not the likely outcomes at the broad asset allocation level. The committee therefore remains committed to strategies that overweight stocks relative to bonds across its mandates and funds.
Shifts in the environment necessitate some changes in investment strategy. European and emerging equities, alongside selective exposure to Japanese mid-caps, are expected to deliver greater earnings upside and are hence preferred positions. Within US equities, growth (via information technology) and quality styles are now preferred to ‘value’.
In fixed income, we remain short of benchmark duration, with a preference for subordinated debt, non-agency mortgage-backed securities and local currency EM.
The low level of realised and implied volatility across most asset classes offers opportunity to hedge portfolio risk in our more conservative strategies.
Within multi-asset target-return strategies, our key investment themes are short duration, long equity beta, long earnings momentum, a preference for mortgage-backed securities, and currency mean-reversion positions.
The overall portfolio stance is predicated on resilient global growth, earnings-driven equity performance and rising bond yields, among other factors.'
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